Where We Are in Consumer Deleveraging

Much has been made of the household deleveraging process, such as how long it will take and how it might affect consumer spending. The housing boom was associated with a huge, parabolic increase in consumer debt -- primarily mortgages and other housing-secured loans, but also credit cards and auto loans. This financed a consumer spending binge, especially from cash-out mortgage refinancings.

Paying off that debt (or eliminating it through default, as the case may be) is commonly thought to be an essential first step before households begin to spend freely again. Knowing where we are in that process of deleveraging is critical to divining consumer spending patterns going forward.

In that vein, the Richmond Fed published a paper, "Where Are Households in the Deleveraging Cycle?" by R. Andrew Bauer and Betty Joyce Nash. They conclude that although households have indeed cut debt through repayment and default, other factors are at play, including income expectations, debt service as a percentage of income and households' balance sheets and net worth across all asset categories. Let's discuss where we are and where we might go from here, using other economic data to guide us.

First, credit innovations had allowed household debt to increase from about 65% or so of disposable personal income prior to the mid-1980s to 90% in 2000. Then, with the housing bubble, debt inflated further, peaking at 129% of disposable personal income at the end of 2007. Most of that increase in debt since 2000 is mortgage related. Since then, through a combination of consumers paying down debt, taking on fewer loans and especially defaulting on debt, that figure is now 113%. It's still high, of course, especially when one considers where we used to be.

However, households have been helped by record low interest rates. Households that were eligible to refinance their mortgages often did so, so the aggregate financial obligations ratio (not just mortgage or rent payments but also auto leases, homeowner's insurance, property taxes, etc.) fell from 19% in 2007 to 16% in the third quarter of 2011, the lowest level since 1993. Just as mortgage debt was responsible for the upswing in debt, the drop in this ratio was concentrated among homeowners.

We can infer a few points from this. Despite aggregate debt that is still high as a percentage of incomes, the cost of servicing that debt has fallen, and that can allow some consumers to spend more. I say "some" because the 22% of homeowners with mortgages who are underwater (according to CoreLogic) could probably not refinance, and their debt-service payments are probably still elevated.

As such, these two groups of homeowners diverge, and this difference is often geographic, as the Richmond Fed's county-by-county analysis shows. This can determine how regional economies may be affected, and in areas where housing prices crashed more and fewer households were able to reduce their debt-service payments, consumer spending may continue to be constrained.

However, there are other factors at play besides households' liabilities and debt service costs. Their assets, and by extension their net worth, also matter. The Richmond Fed research notes that the equity in household real estate peaked at $13.3 trillion in the first quarter of 2006 and plunged to $5.5 trillion in the third quarter of 2011 (in 2005 dollars). Housing prices have not recovered, but stock prices have regained a lot of the lost ground since the bear market. Since wealthier households arguably were less affected by excessive housing debt and hence may be less burdened by underwater mortgages but do have a larger portion of their assets in equities, a rebound in their net worth may portend more higher-end retail spending. Meanwhile, some middle- and lower-income households may still face balance-sheet constraints that limit spending, including psychological and confidence factors.

Of course, probably one of the biggest determinants is income expectations. Households can be more comfortable increasing their spending despite debt levels if they expect their incomes to grow. More income in the future means a greater ability to service existing debts. While we are not quite seeing those expectations rebound to reach pre-recession levels, recent data have become more encouraging. In the Conference Board's Consumer Confidence report, we see that those anticipating more jobs in the months ahead increased to 13.3% from 12.4%, while those anticipating fewer jobs declined to 20.2% from 23.8%. Meanwhile, the proportion of consumers expecting an increase in their incomes improved to 17.1% from 14.1%.

While data on debt levels present a bit of a mixed picture, what's more important is seeing whether the trend of expectations of improving income growth continues. If it does, we may get a rebound in aggregate consumer spending, even if not all households participate equally. If not, then the negative effects of depressed net worth may continue to hamper spending, whether those effects are due to a psychological reluctance or financial inability to take on more credit and increase spending.